A Response to Stavros Gadinis and Eric Pan by Pierre-Hugues Verdier
I would first like to thank Professors Pan and Gadinis for their generous and insightful comments on my article. While it is impossible to offer a full response in this forum, I would like to offer some thoughts on three salient points.
First, as Professor Pan correctly points out, financial cooperation arrangements that share important features of mutual recognition have existed for decades. However, I believe the arrangements described in the article constitute a significant development relative to those prior approaches. Take, for instance, the CFTC’s acceptance of foreign trading screens and PCAOB’s reliance on foreign auditors. Both of these arrangements involve relaxing or waiving host regulatory requirements for entities thought to be appropriately regulated by their home state. Unlike the U.S. and EU programs, however, they are unilateral, in the sense that they are not expressly conditioned on reciprocal recognition by the relevant countries. If, as hypothesized by the article, the promise of reciprocal access can strengthen domestic support by mobilizing export-oriented firms, then we can expect the political dynamics of the unilateral strategy, and the circumstances in which it is likely to succeed, to be different. Likewise, while home country supervision has a venerable pedigree in international banking, instruments such as the Basel Concordat do not expressly link that principle with market access. The Concordat was created, and later strengthened, because banks were thought to be engaging in cross-border activities without adequate coordinated supervision. It is not, however, a mutual recognition arrangement, because members do not commit to admitting foreign banks that meet the standard. They may still prohibit or restrict entry for a host of reasons unless they have made specific commitments under other instruments, like the GATS. Thus, the mutual recognition arrangements discussed in the article are innovative, in my view, because they expressly link regulatory equivalence with a promise of reciprocal, more or less automatic market access. This, in turn, leads to the specific array of benefits, problems and institutional solutions discussed in the article.
Second, I agree with Professor Pan that, given the current methods for determining comparability, mutual recognition arrangements are to some extent “acts of faith.” Whether this means that they are “highly susceptible to failure,” especially on a bilateral basis, is another question. The article argues that since regulators are aware of the difficulties of comparability assessments and effective cross-border cooperation, they will limit their programs to a few, carefully selected partners. As a result, the problem may not be that bilateral arrangements will fail, but that few will be created in the first place, and that those will contribute more to liberalizing market access between developed countries than to enhancing regulation worldwide. With respect to effectiveness, Professor Pan points to another serious issue: adaptability. Can mutual recognition arrangements change over time to respond to changes in financial markets? This issue will likely become more serious over time, because many of the current reforms to address systemic risk involve granting regulators more flexibility to identify and address problems such as systemically important institutions and “crowded trades.” As Professor Gadinis notes, the stakes may also be higher now because mutual recognition could involve relying on the home country to provide financial support to its firms. This is true not only of commercial and investment banks, but also of other institutions that could benefit from mutual recognition like mutual funds, insurance companies, and central derivatives counterparties. In my view, these difficulties reinforce the limitations of bilateral mutual recognition outlined in the article: while they may be surmountable through flexible arrangements between developed markets, they also make widespread adoption by diverse countries unlikely. In this light, it is worth restating that the article is not meant as a call for indiscriminate proliferation of mutual recognition arrangements, but rather as an assessment of their benefits and limitations and the lessons of recent experiences for future efforts.
This leads to the third point, namely the relationship between mutual recognition and TRNs and other forms of international financial governance. Once again, Professor Pan is correct in pointing out that TRNs are a means of furthering regulatory cooperation generally, while mutual recognition is a specific cooperation strategy that TRNs can adopt where appropriate. So far, however, the preferred strategies of TRNs have been to promote supervision and enforcement cooperation arrangements and multilateral harmonization of standards. They have not systematically tried to leverage reciprocal market access through mutual recognition arrangements. There may be several reasons for this, but the leading TRNs’ desire to expand their membership and fend off criticisms of their representativeness and accountability may have made mutual recognition-which could require creating smaller “clubs” within TRNs-unappealing.
Where, then, does this leave us in thinking about the future of international financial governance? I agree with Professor Pan that the political realities that stand in the way of an international financial regulator do not, in and of themselves, prove that the idea is without merit. In fact, given the profound transformations of international finance in recent decades, I am skeptical of arguments that the current system-dominated by soft law and informal networks-adequately addresses contemporary needs. Nevertheless, one must also acknowledge that there are substantial costs and difficulties involved in setting up international regulatory institutions-among them, deadlocks and delays in negotiating common rules, disputes over voting and leadership, and loss of regulatory diversity and competition. These costs require that we carefully consider the possibilities-and limitations-of decentralized alternatives such as mutual recognition.<–>